How to decide which DGFs are worth investing in

It is important to note that diversified growth funds (DGFs) are a type of investment solution and not a distinct asset class, which means the most appropriate DGF will typically vary by client.

To start, we need to ask what the client is looking to achieve from their DGF allocation. This will determine which style (if any) we recommend. We have divided the DGF universe up into the following categories:

• Directional – funds with a moderate to high beta to equities and bonds

• Absolute return – funds with a low beta to equities and bonds

• Other – these funds can either focus on specific areas (eg emerging markets) or liquid alternatives

DB pension schemes

To aid the discussion on which style of DGF is best for defined benefit schemes, we must first understand their existing asset portfolio to ensure against any unintentional overlaps.

Fee levels across the DGF universe can vary significantly, so value for money is also playing an increasingly important role

For example, a directional fund would be more appropriate if a client wanted a higher sensitivity to equity and bond markets, whereas an absolute return fund would be best for clients wishing to have a diversifying return source that is less dependent on wider markets.

As the name suggests, diversification is one of the key selling points of DGFs, although the levels achieved can differ across funds. Directional funds achieve this by investing in multiple asset classes, which helps to reduce overall portfolio volatility.

Absolute return funds, on the other hand, provide better diversification to a DB pension scheme’s overall portfolio because of their low beta to equities and bonds.

DC pension schemes

From a defined contribution perspective, it is vital that the correct style of DGF is selected to do the right job at the right stage of the lifestyle strategy. For the growth phase, diversification and risk management are less important.

Members won’t be as worried about volatility and should be more concerned about achieving upside potential. It is the consolidation phase (from around 15 years off retirement) where we believe DGFs have a significant role to play. This is the stage where members’ pension pots have grown to a size where the focus should be on both growth and capital preservation.

DGFs will have a role to play as long as they provide enough growth on the upside and can deliver protection on the downside. We generally favour directional types of DGFs, but may also use absolute return DGFs as a complement to other asset classes.

Blending DGFs with other asset classes can help ensure the overall charges fall within the fee cap. It is also worth looking at whether a mixed portfolio of assets can be created. This can be rebalanced regularly to achieve a similar result to DGFs without the prohibitively high cost.

How to choose a good DGF

Regardless of client type, once the most appropriate type of DGF has been determined the focus is on choosing the best manager to use. It is important to balance both quantitative analysis of performance and risk with a qualitative assessment of an investment manager’s corporate structure, team, investment philosophy and the quality and robustness of the investment process.

As a result, DGFs are one of the trickiest asset classes to identify manager skill, although performance can be disaggregated in order to accurately assess how much is attributable to luck and how much is down to skill.

Fee levels across the DGF universe can vary significantly, so value for money is also playing an increasingly important role in these selection decisions.

With managers using a variety of methods to implement ideas (active funds, passive funds/ETFs, derivatives, etc) it is vital they are making allocations that are as efficient as possible so that investors are ultimately rewarded.

Adam Porter is associate investment research consultant at Hymans Robertson